How to overcome your behavioural biases

Quant investing has been dubbed a black box. Distilled simply and without any jargon, what makes it different to fundamental investing?

I'd go so far as to say that all of the factors in our process are transparent and fundamentally based. When we think about researching a topic or a potential anomaly in markets, we start with economic rationale. That is front and foremost to how we think about it. We're trying to understand mispricings in markets, mostly based on behavioural biases, and to do that, we need to understand how humans react to these certain circumstances and how that creates mispricing. 

I would actually go so far as to say if someone has a "black box" quant process, run for the hills because I think it's very dangerous. You need to have that transparency because it helps you understand what's working and what isn't working at different times, and also so you can decompose it. It's like having a car, not knowing how to fix the engine, it's a problem. You need to have that transparency and be able to understand what's going on underneath the hood.

What is quant investing? What makes it different?

So what we can do in the quant world is we can apply fundamental analysis on those stocks. We don't go as deep, but we go much broader. So it's all about breadth. And if you ever speak to quants, they'll always go on about breadth, because it's the answer. 

So a really good way to think about it and something I often talk to people about to understand the concept of breadth and getting your expected value in the long term is tossing a coin. You can toss a coin once or twice and you could get two heads or two tails, right? You're not going to get your expected value with such a small sample. If you toss that coin 1,000 times, you're much more likely to get 500 heads, 500 tails or very close to that even distribution. So we call that getting your expected value when applying breadth to it.

And so that's the edge that quant has, it's not about perfection of knowledge but enough knowledge to give you an edge and then applying it in a really consistent way. So I think that's something that quant does very well and that's something that we focus on in our business.

There are over 30,000 stocks in your investment universe. How does a company make its way into the portfolio?

So, it's all about getting consistent results, getting exposure to the best ideas and themes without getting too much stock-specific risk and controlling risk factors like sector exposures and different things like that.

You talked about mispricings and how quant can take advantage of that, what creates market inefficiencies?

So for us, first I'd just say blanket-wise, there are lots of different inefficiencies in markets and you can develop investment styles to try and exploit them. For us, what we're looking for is mispricings that are persistent through time. They're repeatable, and also, they need to have a certain duration. They need to be something you can exploit over a period of time because if it's very short term, it can be an anomaly that's there but you can't actually capture it in real life once you take into account trading costs, etc. So what we look for is enduring repeatable anomalies.

The best way to find those is to find ones that are linked to behavioural biases. As humans, we like to think we're rational but there's a lot of emotion in our decision-making process, and it's that interaction with how investors are looking at securities, assessing the information around securities and mispricing those securities, that creates opportunities for us.

So maybe I'll give you an example that everyone would understand and relate to. So as humans, we tend to over-extrapolate recent events. So where there's some crisis going on at the moment, we tend to say, "Okay, that's happening at the moment. It's a terrible thing or a really good thing." We're going to think that's going to happen in the future for longer than it actually does. So it's called over-extrapolating short-term and not really thinking about the long-term effects. And that happens in the context of markets. Stocks with good news, people will over-extrapolate that too far into the future, not just one year, two years, three years, but they might extrapolate it out 10 years and suddenly, they're pricing a security on unsustainable types of growth.

Equally, for stocks that are going through a really difficult time, people give up on them. People just say, "I don't want to be in that stock anymore. That story is gone. It's too hard. I don't want to go there." So they'll basically discount that stock more than it needs to be. And so you get these mispricings in valuation that's set up based on that behavioural bias, and we just see investors continually repeat that process over and over.

Are there any other long-term human biases investors should be aware of?

The other one that I think has a really strong bias and has actually become worse as social media has become bigger in society is confirmation bias. So if you believe in a certain theory, you can go onto the internet and find someone who's going to support you on that theory. And we have lots of echo chambers now, which are circular, where people speak to people of like minds but they don't go outside of that. And so that just reinforces confirmation bias around ideas, and I think that can also lead to mispricings in securities as well.